Rental Properties – Stay On Top of Your Taxes!
Vacations slowed during the beginning stages of the COVID-19 pandemic, but after being home for so long, people are taking advantage of being able to travel. From VRBO to Airbnb and all of the vacation rental websites in between, travelers have options!
Rental property owners who may have struggled in 2020 are likely doing better in 2021. This, of course, is wonderful news! It is also a good time to give rental property owners a refresher about taxes and the income that needs to be reported.
If you own a rental property, you must report all rental income on your tax return. You can also report any associated expenses as deductions from your rental income.
Three Categories of Rental Properties
The IRS created three categories that are based on the amount of time the owners spend at the property. Each category has different tax implications.
1. Primarily for Personal Use
If a property is rented out for 14 days of the year or less, the earnings do not have to be reported (they are tax-free.)
2. Primarily for Renting
The owner can stay in the property for less than 14 days OR 10% of the total number of days it was rented, and the property is still considered a rental for tax purposes.
3. Renting and Personal Use
If an owner rents a property for more than 14 days of the year and also uses it personally, the property is considered a rental but the deductions will be limited by the rental income. This means that the owner will not count the rental property as a loss for tax purposes.
Calculating Rental Income and Deductible Expenses
According to the IRS, rental income is “any payment you receive for the use or occupation of a property.” Expenses that are “ordinary and necessary” can be deducted from rental income.
Rental income includes:
Rent payments
Advance rent
Security deposits that are not returned to renters
Lease cancellation fees
Services received instead of rent
Deductible expenses for rental properties include:
Mortgage interest
Property tax
Repairs
Utilities
Homeowners insurance
Homeowners association or condo fees
Maintenance and cleaning
Advertising
The rental income listed above is added together to determine the total taxable rental income. The deductible expenses are calculated and then subtracted from the total taxable rental income. Depreciation, which is discussed in the next section, can also be deducted as part of the overall calculation.
Not all expenses associated with a rental property may be deducted on a tax return. Expenses incurred for the cost of improvements may only be deductible through depreciation.
Examples of cost of improvements include:
Restoration
Betterment
Adaptation to a different use
Calculating Depreciation for Rental Properties
Depreciation is a more complicated calculation and occurs over a longer period of time. It depends on the type of improvement and is based on a timetable provided by the IRS.
Improvements that are considered depreciation include:
Renovations
Structural additions
Heating and air conditioning
Insulation
Flooring
Landscaping
Furniture
Rental property depreciation calculators can be found online, but it is also recommended that you consult with a tax professional.
IRS Depreciation and Amortization Form 4562 is used to report depreciation and write off a portion of the property’s value on a tax return.
Reporting Rental Income on a Tax Return
Rental income or loss is reported on IRS Form 1040 or 1040-SR, Schedule E, Supplemental Income and Loss.
Up to 3 properties can be included on one Schedule E, so additional Schedule E forms will have to be submitted if you own more than 3 rental properties. However, the Totals should only be filled in on one of the Schedule E forms and should be a combined total of all Schedule E forms.
Cash Basis vs Accrual Method Taxpayers
There are two different ways rental income can be reported. Taxpayers can either be cash basis or they can use the accrual method.
Most people are cash basis taxpayers and they report income when it is received as opposed to when it was earned. Rental expenses are deducted in the year they are paid rather than when they are incurred.
Accrual taxpayers report income when it is earned instead of when it is received. Expenses are deducted when they are incurred and not when they are paid.
Records to Keep for Tax Returns
It is important to keep detailed records of your property management for your tax return! If you don’t have proof, you may not be able to deduct as much as you had planned. Also, if you are audited, you may be subject to additional taxes and penalties.
Keep These 3 Items on File
1. Financial statements
2. Rent checks
3. Receipts
Owning a rental property is a great way to earn additional income – as long as you stay on top of your taxes!
Please comment below with ideas for topics for upcoming blog posts. Please email us with any questions you have around taxes on rental properties.